Inflation, European Style

Jack Crooks | Saturday, August 23, 2008 at 7:30 am

The public perspective of inflation is mostly vis-à-vis consumer prices — what we’re paying for food, gas, t-shirts and plumbing services. But even while these prices have been the poster child of inflation measures in recent years, there’s more to it than meets the eye.

Producer prices are simply the costs required to produce goods and services. Naturally, when producers’ costs increase they’ll demand higher prices for the goods they produce. In other words, they pass on their costs to their buyers.

Regardless of what type of costs are rising and pushing up prices, those companies who pony up the extra dough to purchase these goods will eventually need to pass on their increased costs to the consumer, with higher prices of their own.

Rising commodity prices tend to be a big reason why producers’ costs rise. More money spent in production means smaller profit margins at current prices. If a producer wants to make up for shrinking profit margins, but can’t control his input costs, then he must pass on these costs in the form of higher prices. Excess money creation is what drives this type of inflation, affording higher prices.

No doubt, this is exactly why the cost of energy has been such a huge driver of the inflationary environment we’ve trudged through over the last several months.

Inflation concerns stem from surging commodity prices.

Debate is increasing as to whether this global inflationary period is coming to an end. I tend to believe it is. But, more importantly, economic growth and available credit across the globe is rolling over at the same time surging commodities have left inflation concerns on everyone’s mind.

For this reason central bank policy makers are struggling.

The cost of energy has buoyed the cost for producers, consumers, and everyone in between. But what happens when this pressure is relieved for a considerable stretch of time?

Federal Reserve and European Central Bank on an Interest Rate Teeter-Totter

They don’t serve ice cubes in their drinks. They drive on the left-hand side of the road. And Inflation is also a little bit different in Europe. Despite this fact, inflation analysis in these respective regions often focuses on generalities and overlooks one particular difference. Let me explain …

Let’s focus only on two countries and two central banks: the U.S. and its Federal Reserve and Europe and its European Central Bank. If you haven’t been hiding under a rock for the last year, then you probably have some kind of idea how their respective policies vary.

The Federal Reserve has knocked off more than 3% from its benchmark interest rate in the last year. In that same time, the European Central Bank has mostly stood its ground, mixing in one rate hike of 25 basis points that brought its benchmark up to 4.25%.

And if you’ve been following my currency commentary in the pages of Money and Markets, you also probably know that this monetary policy discrepancy has been a boon to the euro, and a detriment to the buck. For many months, even years now, the relative performance of each currency has been primarily based upon expectations for this rate differential to change.

Monetary policy discrepancy between the Fed and the ECB has been a boon for the euro — and a detriment to the dollar.

As you might imagine, inflation expectations play an enormous role in monetary policy expectations. And as I said a moment ago, even though inflation has received plenty of attention over the last several months, many analysts have neglected an important difference between European inflation and U.S. inflation.

Now’s the time to pay closer attention.

In the last few weeks, commodity prices (particularly crude oil) have cracked. With that abrupt downturn also came a reprieve in inflation expectations. And that’s got many accepting the potential for a lasting shift towards even lower prices and less inflation pressure.

With that in mind, the dollar has managed to rally on two simple facts:

The U.S. Federal Reserve, which has already lopped off a considerable portion of its benchmark interest rate, is ahead of the rate-cut curve, which has helped maintain some growth in the U.S. relative to Europe. And …

The European Central Bank will be forced to bailout their deteriorating economy by cutting their benchmark interest rate.

Up until this point, the European Central Bank had a good reason to keep fighting inflation. But with commodity prices easing up, now may be the time for ECB policy makers to take action. Here’s why they’ve struggled …

With many threats to global growth and concerns over several Euro area member countries, many have been surprised the ECB has gone so long without letting up on the interest rate front. After all …

The Federal Reserve has made several moves to lower rates;

The Bank of Canada has followed suit;

The Bank of England has gotten the ball rolling,

So has the Reserve Bank of New Zealand, and

The Reserve Bank of Australia is likely next.

If you’re wondering why the ECB hasn’t budged, look no further than labor unions. Simply put: Wage contracts put in place via labor unions have employees’ wages moving higher in lock-step with inflation. There’s really no thought to profitability (the point when workers typically consider demanding higher wages). In other words, rising headline inflation fuels this wage-spiral. And this wage-spiral spurs greater headline inflation. And it continues on like this. That’s something Ben Bernanke hasn’t had to deal with.

You see, the Fed has been able to react to weakening growth by cutting interest rates. The plan: As growth moderates, or rolls over, inflation is likely to follow. But that assumption is more difficult to make when you’ve got rising wages keeping prices unnaturally high. The ECB hasn’t yet been able to make that assumption. Its interest rates remain high.

But here’s what you should expect …

When the ECB finally deems the time appropriate to cut interest rates, they will do so substantially and they will do so quickly. It will be their way of reloading. Because we know, with the labor unions continually eroding profit margins and forcing prices higher, the ECB will need some fire power for their next inflation shoot-out.

If they cut back rates now, they’ll be able to hike rates and combat inflation when the time comes again. All you need to do is be prepared to act accordingly.

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates
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